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How Much Risk Should You Take?

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It's a classic problem that professional money managers and novices alike struggle with.

When should you lever up on risk?

And when should you pull in the reins?

I want to show you how I view this all-important risk vs. reward relationship. Then talk a little about the importance of timing, and finally show you some easy tips to help you better manage risk in the future.

Risk vs. Reward

The essence of investing isn't about earnings, it's not about valuation... it's about risk. You are buying stocks to accept more risk than you would incur if you invested in bonds. You are accepting the risk of stocks versus the safety of treasuries. You take the risk by buying a security that doesn't guarantee a return.

Given that you have accepted the risk of stocks vs. bonds or stocks vs. treasuries, you expect something for that. That extra risk can result in extra return. That is the reward. The more you risk, as the theory goes, the more possible return. Although an excessive amount of risk can have disastrous results.

Measuring Risk

One way to measure the intangible idea of risk is to look at beta. Beta is defined as a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. The basic idea is that a beta of 1.00 means you have the same risk as the rest of the market. A measure of 0.50 means you have 50% of the risk of the market, so less risk. 2.00 would indicate your security or portfolio carries more risk, a lot more risk.

Does this mean that a beta of 1.00 will move with the market in lock step? No. Does it mean that a stock with a beta of 0.80 will not move as much as the market? Not necessarily. Beta is a tool that looks at volatility in the past, but investors would be wise to take this measure at face value. After all, beta is based on what has happened not what is expected to happen.

More . . .


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Should You Take On More Risk?

Hindsight is 20/20, so it is easy to say that it would have been a good time to get aggressive following the May pullback. The gains the broader market posted over the summer months of June, July and most of August could have been magnified if your portfolio was positioned for more risk.

That was then, and this is now. The markets were consolidating and the bulls were ready to charge on to new highs. But what is next? Depending on your view of the next several months, this is either the time to reduce risk for your portfolio or position for more.

A Drill Down Example

Let's say that you have been paying close attention to most of the market over the last several months. You heard numerous companies from a specific sector report earnings. Management spoke in generalities, but for the most part they spoke about big increases in capital expenditures. This was more than a one off, this happened on calls for both big and small companies. This was a signal to buy into this sector!

The key is that management tells you a lot in guidance. They tell you what they think of their customers and their suppliers. It's just not laid out as easy as A, B, C. It's more like 1, 2, 3!

A sector that is seeing big investment is one that is likely to start to show signs of growth in the coming months and quarters. Sometimes its competitors are the ones to invest in, but more often than not it's the suppliers that see the best gains. Those are the ones you need to own.

High Fliers Fall Fast

A studious observer of the markets knows that stocks do not move straight up. Ok, it doesn't take a genius to know that what goes up, almost always comes back down. It just might take some time before the fall.

Let's say that you have made an investment in the right sector after paying attention to guidance. The clues you heard on the conference calls led you to invest in specific suppliers of the industry that is heating up. Now you have some pretty outsized gains sitting in your portfolio, but you again face the age old question of risk vs. reward.

I have found that some stocks will continue to post outsized gains and continue to move higher. Those stocks are very rare though, so don't spend too much time looking for those. Instead focus on the gains you have and look to take some! The best gainers to harvest are often those that have higher beta. That way you pay yourself and reduce your risk at the same time.

Where Are We Headed?

If you believe that the markets are heading higher, you want to take on more risk. Of course if you believe that the market is heading lower, you want to reduce risk. Reducing risk doesn't always have to mean you sell most of your exposure, it can also mean you look for more conservative investments.

A proper portfolio will have a portion of holdings that carry more risk. It will also have holdings that are less risky. In the end, the direction of the overall market has a lot of influence on which end you should be weighted more towards.

Balance the Risk/Reward in Your Portfolio

If you are looking for some guidance on what you should have in your portfolio right now, I invite you to look into Zacks' Home Run Investor service. This portfolio pursues big, long-term gains without taking big risks. It does this by narrowing down the list of strong Zacks Rank stocks to the few that have exceptional potential to blast through the normal 1 to 3-month profit zone and become long term winners.

Currently, this strategy is riding several stocks well into - and beyond - the double digits. One recently boomed +135% in just four months.

Enough about the past. After the market opens Monday, September 30, I am preparing to add a stock with that kind of potential upside. Today, you can arrange to see this fresh home run stock, and a whole lot more, for just $1.

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All the best,

Brian Bolan

Brian is our aggressive growth expert and one of the hottest hands at Zacks who specializes in double-digit stock gains. He is the editor of the Zacks' Home Run Investor.

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